emergent ink

A couple of days ago, when I started this series, I made the following prediction about the price of oil:

I think that it will go over $130 before going under $120, because I see no relief in terms of a sudden increase in production, or decline in demand, or reduction in tensions between the United States and many of the world’s biggest suppliers of oil.

I should clarify that tensions exist because of the other two problems (not enough production, too much demand). But the tensions can take on a life of their own.

Some people have said that the price of oil is being influenced by speculators and the weak dollar. While those factors have some small effect, it’s important to note that oil is not like other products. The laws of supply and demand, and notions of a “bubble” in oil prices that can ‘pop’, will not always apply to oil. To understand why, let’s first look at what happens when you have a “widget bubble”.

Widgets

A Widget, in this case, is a small car. It’s an amazing car; it’s powered by air. It’s also recyclable. That’s a good thing, because Widgets only work for about a week. At the end of each week, Widget owners return their drained Widgets to the dealer, and buy a new one. Obviously, Widgets don’t cost as much as cars with internal combustion engines. They go for around $50.

Widget sales take off. Widget dealerships pop up everywhere. Demand is huge for these cars. Waiting lists are long as production ramps up, and people overpay for the privilege of being the first in their neighborhood to own a Widget. Eventually, half the US is driving around in Widgets. When Widget Corp. can’t make enough of them because of delays in constructing new Widget factories, the price goes up. Congressmen accuse Widget Corp. of having obscene profits when their annual report comes out. Then it happens.

All these Americans driving past gas stations in their Widgets cause a drop in demand for gasoline. The price of gas drops below $2/gallon. The cost of maintaining an old-fashioned, internal combustion engine vehicle that burns fossil fuels becomes less than the cost of a Widget, and you can own your car for more than a week at a time. People fall for nostalgia and the “good old days” before the hassle of buying new recyclable, air-fueled Widgets every week.

Widget Corp. finds itself with hundreds of thousands of unused Widgets lying around, and starts discounting them. Widget Corp. share prices plummet. Dealerships go out of business.

Eventually, Widgets cost less than cars again, and the process continues.

The point I am trying to make is that things like supply and demand and pricing bubbles work when you talk about products like Widgets. If you only need to build a new factory in order to make more of them, and all that takes is money and labor, then you can always keep up with demand. But widget builders have to be careful. If demand should drop, for any reason, then they will be in a position of oversupply. That will slow sales, increase available product, force a drop in price. Another point to take away from this hypothetical, oversimplified, if-only example is that you have to watch out for external factors that can impact demand and therefore price.

Peak Oil

The difference between widgets and oil is that there is a limited amount of oil in the world. Up until now, we have been able to find and produce more, to keep up with demand. But that is no longer possible. Most people do not realize this yet. Some speculators are counting on it.

Peak Oil is not what happens when we run out of oil; it’s what happens when we can’t produce as much oil as we did before. Given that demand keeps going up, you start to see a gap between supply and demand, and that causes the price to go up beyond our control. Once we pass the peak, there is no more guessing involved. The price is going up. I believe that’s the situation now.

Here are three good Peak Oil primers, explaining the theory better than I can:

Energy Bulletin: Peak Oil Primer

The Oil Drum: Peak Oil Overview – March 2008

Hubbert Peak for World Oil: Summary

There’s one other thing to note about Widget Corp. When I said that all it takes to build a new factory and make more Widgets is money and labor, I left out something very important but practically invisible, and that is energy. It takes electricity to make those Widgets, and it takes diesel to mine for the metals, oil to make the plastics, and more diesel to ship materials to the factories and finished Widgets to the dealerships. Just like everything else that is made today, including our food. We take for granted that there will always be more available energy to build more things for us to consume. The stock market depends on growth, and that depends on there always being more available, cheap energy. That is the inescapable fact of the world we used to live in.

Bloomberg: Oil Rises to a Record After Pickens Says Prices May Reach $150

Producers are “running out of oil,” Pickens, the founder and chairman of Dallas-based BP Capital LLC, said on CNBC today…

“It’s not just Boone Pickens; just about every big global bank has raised its price forecast in recent weeks,” said John Kilduff, vice president of risk management at MF Global Ltd. in New York. “When prices last fell below $20 in 2001 there was a surplus. That’s no longer the case. There’s now a deficit.”

Production Has Peaked

A couple of days ago, Saudi Arabia announced that it would increase output by 300,000 barrels a day, but there was no change in direction for the price of oil. From Bloomberg.com:

Crude oil was little changed amid skepticism that Saudi Arabia’s decision to increase output by 300,000 barrels a day will be sufficient to reduce prices. Saudi Arabia will boost production by about 3.3 percent to 9.45 million barrels a day in June, Oil Minister Ali al-Naimi said in Riyadh on May 16.

Maybe the reason this announced increase in production is not going to have an effect is because there’s no real increase taking place. Here are some numbers related to Saudi petroleum production:

• 9.15 mbpd (million barrels per day): what Saudi Arabia is currently producing, from Bloomberg.com
• 9.45 mbpd: what Saudi Arabia will boost its production to in June, according to Saudi Oil Minister Ali al-Naimi
• 12.5 mbpd: what al-Naimi said Saudi Arabia would be capable of producing in 2009, according to this article from the Islamic Republic News Agency (IRNA). (“That is substantial spare capacity. As far as I know, all the latest projections, at least up to 2020, do not require anything higher than that,” al-Naimi added.)
• 16.4 mbpd: what the US EIA (Energy Information Agency) projects Saudi Arabia to be producing in 2030
• 23.8 mbpd: what the EIA projected Saudi Arabia to be producing by 2025 (back in 2003; they don’t expect that any more)

According to IRNA, the International Energy Agency (IEA) calculates that “if all the policies to increase renewable fuels and to use oil more efficiently were to be enacted on Tuesday, the world would still need OPEC’s daily production to increase by 11.5m barrels by 2030, the bulk of which would have to come from its biggest members, such as Saudi Arabia. That is a tall order. It is more than 50 percent more than OPEC has managed to increase output during 1980 to 2006.”

What is a reasonable amount to expect Saudi Arabia to be able to produce, to satisfy the increasing global demand for oil? Let’s look at what they actually have managed to produce in the past:

• 9.9 mbpd: The largest amount of oil produced by Saudi Arabia (in 1980)
• 9.6 mbpd: The last time Saudi Arabia produced this much oil was in 2005

In the first part of this series, I presented an example of what happens when you try to extract more oil from a field. You can increase production to a point by adding wells and using new methods of extraction, but ultimately, you can only get so much oil out of the ground. Here’s a chart comparing the number of oil rigs to the amount of oil production between Jan 2002 and Jan 2007.

You can see that there have been more wells added, but production has stayed flat or gone down. This chart, and a lot of great insight into Saudi Arabian oil production by Stuart Staniford, can be found on The Oil Drum website.

The Oil Drum: A Nosedive Toward the Desert

By the way, Saudi Arabia and OPEC had a price band that they tried to keep oil within. The band had a low limit, and OPEC would limit production in order to keep the price of a barrel up above that limit. The band also had a high limit, and OPEC would increase production because that limit was the point where, according to their analysis, there would be a negative impact on the market (worldwide recession, people looking for alternatives to oil). That makes sense, if you can control production. The last time OPEC was able to keep oil in that price band ($22-$28/barrel) was January 2004.

It is becoming apparent that there can no longer be any real increase in production. Production will start to decline, erratically at first but drastically (compared to current and future demand) before too long.

The data may not be very good, as far as reserves and production numbers go. While that complicates any attempts at accurate predictions, it does not excuse us from recognizing that there is a crisis headed our way. It will be bad; the Hirsch Report talks about mitigation if we have decades to prepare, and we don’t. Urgent action is needed, now.

High prices are just a symptom of the gap between falling production and rising demand. The real hurt is hiding behind the price. The United States is responsible for 2% of global oil production but consumes 24% of it. I’ll go into that next time.